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Chapter 11, Part A

Inventory Models: Deterministic Demand

Economic Order Quantity (EOQ) Model


Economic Production Lot Size Model
Inventory Model with Planned Shortages
Quantity Discounts for the EOQ Model

2005 Thomson/South-Western

Inventory Models

The study of inventory models is concerned


with two basic questions:
How much should be ordered each time
When should the reordering occur
The objective is to minimize total variable
cost over a specified time period (assumed
to be annual in the following review).

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Inventory Costs

Ordering cost -- salaries and expenses of


processing an order, regardless of the order
quantity
Holding cost -- usually a percentage of the value of
the item assessed for keeping an item in inventory
(including finance costs, insurance, security costs,
taxes, warehouse overhead, and other related
variable expenses)
Backorder cost -- costs associated with being out
of stock when an item is demanded (including lost
goodwill)
Purchase cost -- the actual price of the items
Other costs

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Deterministic Models

The simplest inventory models assume


demand and the other parameters of the
problem to be deterministic and constant.
The deterministic models covered in this
chapter are:
Economic order quantity (EOQ)
Economic production lot size
EOQ with planned shortages
EOQ with quantity discounts

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Economic Order Quantity (EOQ)

The most basic of the deterministic


inventory models is the economic order
quantity (EOQ).
The variable costs in this model are annual
holding cost and annual ordering cost.
For the EOQ, annual holding and ordering
costs are equal.

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Economic Order Quantity

Assumptions
Demand is constant throughout the year at
D items per year.
Ordering cost is $Co per order.
Holding cost is $Ch per item in inventory per
year.
Purchase cost per unit is constant (no
quantity discount).
Delivery time (lead time) is constant.
Planned shortages are not permitted.

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Economic Order Quantity

Formulas

Optimal order quantity:

Q*=

Number of orders per year:

2DCo/Ch

D/ Q *

Time between orders (cycle time):


years

Total annual cost:

Q */D

[(1/2)Q *Ch] + [DCo/Q *]


(holding + ordering)

2005 Thomson/South-Western

Example: Barts Barometer Business

Economic Order Quantity Model


Bart's Barometer Business is a retail outlet
that
deals exclusively with weather equipment.
Bart is trying to decide on an inventory
and reorder policy for home barometers.
Barometers cost Bart $50 each and
demand is about 500 per year distributed
fairly evenly throughout the year.

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Example: Barts Barometer Business

Economic Order Quantity Model


Reordering costs are $80 per order and
holding
costs are figured at 20% of the cost of the
item. BBB is
open 300 days a year (6 days a week and
closed two
weeks in August). Lead time is 60 working
days.

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Example: Barts Barometer Business

Total Variable Cost Model


Total Costs
= (Holding Cost) +
(Ordering Cost)
TC
= [Ch(Q/2)] + [Co(D/Q)]
= [.2(50)(Q/2)] + [80(500/Q)]
= 5Q + (40,000/Q)

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Example: Barts Barometer Business

Optimal Reorder Quantity


Q * = 2DCo /Ch =
89.44 90

2(500)(80)/10 =

Optimal Reorder Point


Lead time is m = 60 days and daily
demand is
d = 500/300 or 1.667.
Thus the reorder point r = (1.667)(60) =
100. Bart should reorder 90 barometers when
his inventory position reaches 100 (that is 10
on hand and one outstanding order).

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Example: Barts Barometer Business

Number of Orders Per Year


Number of reorder times per year = (500/90)
= 5.56 or once every (300/5.56) = 54
working days (about every 9 weeks).

Total Annual Variable Cost


TC = 5(90) + (40,000/90) = 450 + 444 =
$894.

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Example: Barts Barometer Business


Well now use a spreadsheet to implement
the Economic Order Quantity model. Well
confirm
our earlier calculations for Barts problem and
perform some sensitivity analysis.
This spreadsheet can be modified to
accommodate
other inventory models presented in this
chapter.

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Example: Barts Barometer Business

Partial Spreadsheet with Input Data


A
B
1 BART'S ECONOMIC ORDER QUANTITY
2
3
Annual Demand
500
4
Ordering Cost
$80.00
5
Annual Holding Rate %
20
6
Cost Per Unit
$50.00
7
Working Days Per Year
300
8
Lead Time (Days)
60

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Example: Barts Barometer Business

Partial Spreadsheet Showing Formulas for Output


A
10 Econ. Order Qnty.
11 Request. Order Qnty
12 % Change from EOQ
13
14 Annual Holding Cost
15 Annual Order. Cost
16 Tot. Ann. Cost (TAC)
17 % Over Minimum TAC
18
19 Max. Inventory Level
20 Avg. Inventory Level
21 Reorder Point
22
23 No. of Orders/Year
24 Cycle Time (Days)

B
C
=SQRT(2*B3*B4/(B5*B6/100))
=(C11/B10-1)*100
=B5/100*B6*B10/2
=B4*B3/B10
=B14+B15

=B5/100*B6*C11/2
=B4*B3/C11
=C14+C15
=(C16/B16-1)*100

=B10
=B10/2
=B3/B7*B8

=C11
=C11/2
=B3/B7*B8

=B3/B10
=B10/B3*B7

=B3/C11
=C11/B3*B7

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Example: Barts Barometer Business

Partial Spreadsheet Showing Output


A
10 Econ. Order Qnty.
11 Request. Order Qnty.
12 % Change from EOQ
13
14 Annual Holding Cost
15 Annual Order. Cost
16 Tot. Ann. Cost (TAC)
17 % Over Minimum TAC
18
19 Max. Inventory Level
20 Avg. Inventory Level
21 Reorder Point
22
23 No. of Orders/Year
24 Cycle Time (Days)

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C
89.44
75.00
-16.15
$447.21
$447.21
$894.43

$375.00
$533.33
$908.33
1.55

89.44
44.72
100

75
37.5
100

5.59
53.67

6.67
45.00

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Example: Barts Barometer Business

Summary of Spreadsheet Results


A 16.15% negative deviation from the EOQ
resulted in only a 1.55% increase in the
Total Annual Cost.
Annual Holding Cost and Annual Ordering
Cost are no longer equal.
The Reorder Point is not affected, in this
model, by a change in the Order Quantity.

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Economic Production Lot Size

The economic production lot size model is a


variation of the basic EOQ model.
A replenishment order is not received in one
lump sum as it is in the basic EOQ model.
Inventory is replenished gradually as the order
is produced (which requires the production
rate to be greater than the demand rate).
This model's variable costs are annual holding
cost and annual set-up cost (equivalent to
ordering cost).
For the optimal lot size, annual holding and
set-up costs are equal.

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Economic Production Lot Size

Assumptions
Demand occurs at a constant rate of D
items per year.
Production rate is P items per year (and P
> D ).
Set-up cost: $Co per run.
Holding cost: $Ch per item in inventory per
year.
Purchase cost per unit is constant (no
quantity discount).
Set-up time (lead time) is constant.
Planned shortages are not permitted.

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Economic Production Lot Size

Formulas

Optimal production lot-size:


Q*=

2DCo /[(1-D/P )Ch]

Number of production runs per year:


Time between set-ups (cycle time):
years

Total annual cost:

D/Q *

Q */D

[(1/2)(1-D/P )Q *Ch] +

[DCo/Q *]

(holding + ordering)
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Example: Non-Slip Tile Co.

Economic Production Lot Size Model


Non-Slip Tile Company (NST) has been using
production runs of 100,000 tiles, 10 times per year
to meet the demand of 1,000,000 tiles
annually. The set-up cost is $5,000 per
run and holding cost is estimated at
10% of the manufacturing cost of $1
per tile. The production capacity of
the machine is 500,000 tiles per month. The
factory
is open 365 days per year.

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Example: Non-Slip Tile Co.

Total Annual Variable Cost Model


This is an economic production lot size
problem with
D = 1,000,000, P = 6,000,000, Ch = .10, Co
= 5,000
Costs)

TC

= (Holding Costs) + (Set-Up

= [Ch(Q/2)(1 - D/P )] + [DCo/Q]


= .04167Q + 5,000,000,000/Q

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Example: Non-Slip Tile Co.

Optimal Production Lot Size


Q*=
1/6)]

2DCo/[(1 -D/P )Ch]

2(1,000,000)(5,000) /[(.1)(1 -

346,410

Number of Production Runs Per Year


D/Q * =

2.89

times per year.

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Example: Non-Slip Tile Co.

Total Annual Variable Cost


How much is NST losing annually by using
their present production schedule?
Optimal TC = .04167(346,410) +
5,000,000,000/346,410
= $28,868
Current TC
= .04167(100,000) +
5,000,000,000/100,000
= $54,167
Difference = 54,167 - 28,868 = $25,299

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Example: Non-Slip Tile Co.

Idle Time Between Production Runs


There are 2.89 cycles per year. Thus, each
cycle lasts (365/2.89) = 126.3 days. The time
to produce 346,410 per run =
(346,410/6,000,000)365 = 21.1 days. Thus,
the machine is idle for:
126.3 - 21.1 =
runs.

105.2

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days between

25

Example: Non-Slip Tile Co.

Maximum Inventory
Current Policy:
Maximum inventory = (1-D/P )Q *
= (1-1/6)100,000
83,333
Optimal Policy:
Maximum inventory = (1-1/6)346,410 =
288,675

Machine Utilization
Machine is producing D/P =
time.

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of the

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EOQ with Planned Shortages

With the EOQ with planned shortages model, a


replenishment order does not arrive at or
before the inventory position drops to zero.
Shortages occur until a predetermined
backorder quantity is reached, at which time
the replenishment order arrives.
The variable costs in this model are annual
holding, backorder, and ordering.
For the optimal order and backorder quantity
combination, the sum of the annual holding
and backordering costs equals the annual
ordering cost.

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EOQ with Planned Shortages

Assumptions
Demand occurs at a constant rate of D
items/year.
Ordering cost: $Co per order.
Holding cost: $Ch per item in inventory per year.

Backorder cost: $Cb per item backordered per

year.
Purchase cost per unit is constant (no qnty.
discount).
Set-up time (lead time) is constant.
Planned shortages are permitted (backordered
demand units are withdrawn from a replenishment
order when it is delivered).
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EOQ with Planned Shortages

Formulas
Optimal order quantity:
Q * = 2DCo/Ch
(Ch+Cb )/Cb
Maximum number of backorders:
S * = Q *(Ch/(Ch+Cb))

Number of orders per year: D/Q *


Time between orders (cycle time): Q */D years
Total annual cost:
[Ch(Q *-S *)2/2Q *] + [DCo/Q *] + [S *2Cb/2Q
*]
(holding + ordering + backordering)
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Example: Hervis Rent-a-Car

EOQ with Planned Shortages Model


Hervis Rent-a-Car has a fleet of 2,500
Rockets
serving the Los Angeles area. All Rockets are
maintained at a central garage. On
the average, eight Rockets per
month require a new engine.
Engines cost $850 each. There
is also a $120 order cost
(independent of the number of
engines ordered).

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Example: Hervis Rent-a-Car

EOQ with Planned Shortages Model


Hervis has an annual holding cost rate of
30% on
engines. It takes two weeks to obtain the
engines after
they are ordered. For each week a car is out of
service,
Hervis loses $40 profit.

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Example: Hervis Rent-a-Car

Optimal Order Policy


D = 8 x 12 = 96; Co = $120; Ch = .30(850) =
$255;
Cb = 40 x 52 = $2080
Q*=
=

2DCo/Ch

(Ch + Cb)/Cb

2(96)(120)/255 x

(255+2080)/2080

= 10.07 10
S * = Q *(Ch/(Ch+Cb))
= 10(255/(255+2080)) = 1.09 1
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Example: Hervis Rent-a-Car

Optimal Order Policy (continued)


Demand is 8 per month or 2 per week.
Since
lead time is 2 weeks, lead time demand is 4.
Thus, since the optimal policy is to order 10
to
arrive when there is one backorder, the order
should
be placed when there are 3 engines remaining
in
inventory.

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Example: Hervis Rent-a-Car

Stockout: When and How Long


Question:
How many days after receiving an order does
Hervis run out of engines? How long is Hervis
without any engines per cycle?

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Example: Hervis Rent-a-Car


Stockout: When and How Long
Answer
Inventory exists for Cb/(Cb+Ch) = 2080/
(255+2080)
= .8908 of the order cycle. (Note, (Q *-S *)/Q * =
.8908
also, before Q * and S * are rounded.)
An order cycle is Q */D = .1049 years = 38.3
days.
Thus, Hervis runs out of engines .8908(38.3) =
34 days
after receiving an order.
Hervis is out of stock for approximately 38 2005 Thomson/South-Western
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34 = 4

EOQ with Quantity Discounts

The EOQ with quantity discounts model is


applicable where a supplier offers a lower
purchase cost when an item is ordered in
larger quantities.
This model's variable costs are annual holding,
ordering and purchase costs.
For the optimal order quantity, the annual
holding and ordering costs are not necessarily
equal.

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EOQ with Quantity Discounts

Assumptions
Demand occurs at a constant rate of D
items/year.
Ordering Cost is $Co per order.
Holding Cost is $Ch = $CiI per item in
inventory per year (note holding cost is
based on the cost of the item, Ci).
Purchase Cost is $C1 per item if the quantity
ordered is between 0 and x1, $C2 if the order
quantity is between x1 and x2 , etc.
Delivery time (lead time) is constant.
Planned shortages are not permitted.

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EOQ with Quantity Discounts

Formulas

Optimal order quantity:

the procedure for


determining Q * will be demonstrated
Number of orders per year: D/Q *
Time between orders (cycle time): Q */D
years
Total annual cost: [(1/2)Q *Ch] + [DCo/Q *] +
DC
(holding + ordering +
purchase)

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Example: Nick's Camera Shop

EOQ with Quantity Discounts Model


Nick's Camera Shop carries Zodiac instant
print
film. The film normally costs Nick $3.20
per roll, and he sells it for $5.25. Zodiac
film has a shelf life of 18 months.
Nick's average sales are 21 rolls per
week. His annual inventory holding
cost rate is 25% and it costs Nick $20 to place an
order
with Zodiac.

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Example: Nick's Camera Shop

EOQ with Quantity Discounts Model


If Zodiac offers a 7% discount on orders of
400
rolls or more, a 10% discount for 900 rolls or
more,
and a 15% discount for 2000 rolls or more,
determine
Nick's optimal order quantity.
-------------------D = 21(52) = 1092; Ch = .25(Ci); Co = 20

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Example: Nick's Camera Shop

Unit-Prices Economical Order Quantities


For C4 = .85(3.20) = $2.72
To receive a 15% discount Nick must order
at least 2,000 rolls. Unfortunately, the film's shelf
life is 18 months. The demand in 18 months (78
weeks) is 78 X 21 = 1638 rolls of film.
If he ordered 2,000 rolls he would have to
scrap 372 of them. This would cost more than the
15% discount would save.

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Example: Nick's Camera Shop

Unit-Prices Economical Order Quantities


For C3 = .90(3.20) = $2.88
Q3* = 2DCo/Ch =
2(1092)(20)/[.25(2.88)] =
246.31
(not feasible)
The most economical, feasible quantity for C3 is 900.

For C2 = .93(3.20) = $2.976


Q2* = 2DCo/Ch = 2(1092)(20)/[.25(2.976)] =
242.30
(not feasible)
The most economical, feasible quantity for C2 is 400.

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Example: Nick's Camera Shop

Unit-Prices Economical Order Quantities


For C1 = 1.00(3.20) = $3.20
Q1* = 2DCo/Ch = 2(1092)(20)/.25(3.20) =
233.67
(feasible)
When we reach a computed Q that is
feasible we stop computing Q's. (In this problem
we have no more to compute anyway.)

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Example: Nick's Camera Shop

Total Cost Comparison


Compute the total cost for the most economical, feasible
order quantity in each price category for which a Q *
was computed.

TCi = (1/2)(Qi*Ch) + (DCo/Qi*) + DCi


TC3 = (1/2)(900)(.72) +((1092)(20)/900)+(1092)(2.88) =
3493
TC2 = (1/2)(400)(.744)+((1092)(20)/400)+(1092)(2.976) =
3453
TC1 = (1/2)(234)(.80) +((1092)(20)/234)+(1092)(3.20) =
3681
Comparing the total costs for 234, 400 and 900, the
lowest total annual cost is $3453. Nick should order 400
rolls at a time.

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End of Chapter 11, Part A

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